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Cerner (NASDAQ:CERN)

Q1 2014 Earnings Call

April 24, 2014 4:30 pm ET

Executives

Marc G. Naughton - Chief Financial Officer, Executive Vice President and Treasurer

Zane M. Burke - President

Michael R. Nill - Chief Operating Officer and Executive Vice President

Jeffrey A. Townsend - Chief of Staff and Executive Vice President

Analysts

Richard C. Close - Avondale Partners, LLC, Research Division

Mohan A. Naidu - Stephens Inc., Research Division

Michael P. Ward - Sterne Agee & Leach Inc., Research Division

Steven Valiquette - UBS Investment Bank, Research Division

Jamie Stockton - Wells Fargo Securities, LLC, Research Division

David K. Francis - RBC Capital Markets, LLC, Research Division

Eric Krueger

Leo F. Carpio - HM Global Capital LLC, Research Division

Garen Sarafian - Citigroup Inc, Research Division

Charles Rhyee - Cowen and Company, LLC, Research Division

Michael Cherny - ISI Group Inc., Research Division

George Hill - Deutsche Bank AG, Research Division

Operator

Welcome to the Cerner Corporation's First Quarter 2014 Conference Call. Today's date is April 24, 2014, and this call is being recorded.

The company has asked me to remind you that various remarks made here today constitute forward-looking statements, including without limitation, those regarding projections of future revenues or earnings, operating margins, operating expenses, product development and new markets or prospects for the company's solutions. Actual results may differ materially from those indicated by the forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements may be found under Item 1A in Cerner's Form 10-K together with the company's other filings.

A reconciliation of non-GAAP financial measures discussed in this earnings call can be found in the company's earnings release, which was furnished to the SEC today and posted on the Investors section of cerner.com.

At this time, I would like to turn the call over to Marc Naughton, Chief Financial Officer of Cerner Corporation. Please proceed.

Marc G. Naughton

Thank you. Good afternoon, everyone, and welcome to the call. I'll lead off today with a review of the numbers. Zane Burke, our President, will follow me with the results, highlights and marketplace observations. Mike Nill, Executive Vice President and Chief Operating Officer, will discuss our imperatives. And then Jeff Townsend, Executive Vice President and Chief of Staff, will provide an update on our focus on innovation with Intermountain Healthcare. Neal Patterson, our Chairman and CEO, is with a client today.

Now I will turn to our results. Our total bookings revenue in Q1 was $910 million, which is an all-time high for a first quarter and reflects 14% growth over our previous Q1 record results in Q1 of '13.

Bookings margin in Q1 was $824 million or 91% of total bookings. Our bookings performance drove a 22% increase in total backlog to 900-point -- $9.24 billion. Contract revenue backlog of $8.45 billion is 24% higher than a year ago. Support revenue backlog of $796 million is up 6%.

Revenue in the quarter was $785 million, which is up 15% over Q1 of '13. The revenue composition for Q1 was $207 million in system sales, $175 million in support and maintenance, $382 million in services and $21 million in reimbursed travel.

System sales revenue reflects a 4% increase over Q1 of '13, due to the growth in software and subscription revenue, which offset another decline in technology resale. The tech resale decline was, in part, due to a tough comparable in our global business where we had a large hardware sale in the year-ago period. But the rest of tech resale was also below our expectations. Our forecast reflects growth in tech resale for the rest of the year.

Q1 system sales margin dollars grew 21% over the year-ago period, driven by continued strong levels of the higher-margin system sales components of software and subscriptions.

Moving to services. Total services revenue was up 25% compared to Q1 of '13, with strong growth in managed services and professional services and good contributions from ITWorks and RevWorks. Support and maintenance revenue increased 9% over Q1 of '13.

Looking at revenue by geographic segment. Domestic revenue increased 21% for the quarter. Global revenue was down 16% from Q1 of '13, which, as I mentioned, was a tough comparable for global. Zane will discuss our global outlook for the rest of the year, which is very good.

Moving to gross margin. Our gross margin for Q1 was 83.5%, which is up from 81.3% in Q1 of '13, reflecting strong software and subscription levels and a lower mix of technology resale.

Looking at operating spending. Our first quarter operating expenses were $463 million before share-based compensation expense. This is a year-over-year increase of 20%. Sales in client service expenses increased 23% compared to Q1 of '13, driven by an increase in revenue-generating associates in our services businesses and growth in depreciation.

Our investment in software development was up 12% compared to Q1 of '13. As previously discussed, the growth in software development is due to increased focus on investing in growth initiatives.

G&A expense increased 15% compared to Q1 of '13, driven by increased personnel expense related to our strong growth and higher amortization expense, related to recent acquisitions and acquired intangibles.

Moving to operating margins. Our operating margin in Q1 was 24.6% before share-based compensation expense. This is down 10 basis points compared to Q1 of '13, due to slightly higher growth in operating expenses. Our forecast for the rest of the year reflects approximately 100 basis points of margin expansion, with less than that next quarter and more in Q3 and Q4.

As you know, this can vary based on revenue mix, and we will focus on delivering predictable levels of growth in gross margin and earnings dollars, which we did this quarter without margin expansion.

Moving to net earnings and EPS. Our GAAP net earnings in Q1 were $119.5 million or $0.34 per diluted share. GAAP net earnings include share-based compensation expense, which had a net impact on earnings of $9.6 million or $0.03 per diluted share. Adjusted net earnings were $129.1 million, and adjusted EPS was $0.37, which is up 11% compared to Q1 of '13. Recall that Q1 '13 had a lower tax rate that benefited adjusted EPS by $0.01. If you adjust Q1 of '13 for this, our normalized growth this quarter would be 14%.

The Q1 tax rate for adjusted net earnings was 34%, which is in line with our expected effective tax rate. For the remainder of 2014, we expect our effective tax rate to remain within 50 to 100 basis points of 34%.

Now I'll move to our balance sheet. We ended Q1 with $1.47 billion of total cash and investments compared to $1.43 billion in Q4. Total cash and investments include $1.03 billion of cash and short-term investments and $437 million of highly rated corporate and government bonds with maturities less than 2 years. Our total debt, including capital lease obligations, is $160 million.

Total receivables ended the quarter at $564 million, which is down $19 million from Q4. Our DSO in Q1 was 66 days, which is down from the Q4 DSO of 67 days and down from 69 days in Q1 of '13.

Operating cash flow for the quarter was $156 million. Q1 capital expenditures were $70 million, and capitalized software was $45 million. Free cash flow, defined as operating cash flow less capital expenditures and capitalized software, was $42 million for the quarter.

Looking at capitalized software, the $45 million of capitalized software in Q1 represents 40% of the $111 million of total investment in development activities. Software amortization for the quarter was $25 million, resulting in net capitalization of $19 million or 18% of our total R&D investment.

Note that operating cash flow was impacted in Q1 by the timing of tax payments and other working capital elements, which reduced operating cash flow by over $80 million as compared to Q1 of '13.

Also I wanted to point out that we received a $48 million cash grants in Q1 from the Kansas Department of Commerce in connection with the construction of our Continuous Campus. While this will show up in the financing section of our cash flow, it's not really debt, and I view it as another element of cash flow. Looking at the rest of the year, we expect stronger operating cash flow and, as a result, stronger free cash flow.

Our outlook for capital expenditures and capitalized software remains the same as what we provided last quarter. We expect capital expenditures to be $260 million to $280 million for the year, which is down from $353 million in 2013. We expect capitalized software to remain in the mid-$40 million range throughout the year, which will lead to it being flat or slightly higher than the $175 million capitalized in 2013. This reflects a reduction in the use of third-party developers, which will be offset slightly by an increase in our own developers.

Regarding our share buybacks. We purchased 1.3 million of shares for approximately $75 million during the quarter, and now have $142 million remaining from the $217 million that was authorized in December.

Now we'll go through Q2 and full year 2014 guidance. For Q2, we expect revenue between $790 million and $830 million, with the midpoint reflecting growth of 14% over Q2 of '13. For the full year, we expect revenue between $3.25 billion and $3.4 billion, reflecting 14% growth at the midpoint. This is up from our prior range of $3.2 billion to $3.4 billion.

We expect Q2 adjusted EPS, before share-based compensation expense, to be $0.39 to $0.40 per share, with the midpoint reflecting 16% growth over Q2 '13 adjusted EPS.

Q2 guidance is based on total spending before share-based compensation expense of approximately $470 million to $480 million. For the full year, we expect adjusted EPS between $1.63 and $1.67, with the midpoint reflecting 17% growth. This is up slightly from our prior range of $1.62 to $1.67. Our estimate for the impact of share-based compensation expense is approximately $0.03 in Q2 and $0.11 to $0.12 for the full year.

Moving to bookings guidance. We expect bookings revenue in Q2 of $1.0 billion to $1.06 billion, with the midpoint reflecting 10% growth over Q2 of '13, which is our toughest comparable of the year, having grown 33% over 2012.

In summary, we're pleased with our results in Q1 and believe we are positioned for a good year. With that, I will turn the call over to Zane.

Zane M. Burke

Thanks, Marc. Good afternoon, everyone. Today, I'll provide Q1 highlights and discuss marketplace trends.

Starting with our results. Our bookings revenue in Q1 of $910 million reflects 14% growth over Q1 2013 and that's a record for a first quarter. This growth was achieved despite another weak quarter of technology resale.

In addition, we had no new ITWorks or RevWorks deals in the quarter, but we did have contributions from scope expansions at existing ITWorks clients and good sales of Revenue Cycle solutions. For the quarter, we had 23 contracts over $5 million, including 13 over $10 million. The mix of long-term bookings was 28% in the quarter, which is lower than recent quarters because of less contribution from the Works businesses. Note that our pipeline is strong for our Works businesses, and we still expect to have a very good bookings this year.

25% of our bookings this quarter came from outside of our core Millennium installed base, reflecting ongoing competitiveness. As we highlighted at our recent Investor Day, we continue to have significant opportunities to gain share, as we believe we are in the early stages of another wave of EMR purchases that will disproportionately go to Cerner or our primary competitor. With our win rate against this competitor significantly improved, we are positioned for good share gains in coming years.

The volume of potential new business was also very apparent at HIMSS this year, where we interacted with more potential new clients than we ever have.

Now I'll cover some of the specific areas that contributed to our Q1 results. I'll start with Revenue Cycle. While we didn't have a RevWorks deal in Q1, contribution from Revenue Cycle was still good. This was driven by ongoing sales of our broad suite of Revenue Cycle solutions. Our forecast for the year calls for ongoing strength in solution sales and increased contribution from RevWorks.

Overall, the outlook for our Revenue Cycle business remains positive, as revenue and costs are top of mind for all providers, and the importance of Revenue Cycle being integrated with clinical solutions continues to increase as the industry shifts to at-risk models.

The opportunity is significant in our installed base, as many of our large clients are still on antiquated Revenue Cycle solutions. Revenue Cycle is also part of almost every opportunity for our business outside our base, and the improvements we have made in recent years have been an important part of our increased competitiveness.

In addition, we think the delay in ICD-10 will be a slight positive to our Revenue Cycle business because we had some prospects that were going to wait until after the deadline to install new solutions that can now consider installing them before the new deadline.

Our population health organization also delivered strong results, driven by demand for HIE, Patient Portal, Enterprise Data Warehouse and clinical process optimization. In addition, we had additional sales of our new Healthe Intent Smart Registries solution and have a strong pipeline for the year.

Moving to the ambulatory space where we had a strong Q1, with our clients continuing to favor our integrated offering over standalone solutions, we had 6 significant displacements of our key competitors and 2 strategic Business Office Services deals during the quarter. We also had a very good quarter in the small hospital market, adding 5 new CommunityWorks clients, bringing 8 clients live, and hosting a record level of prospective clients in our Vision Center.

Outside of the U.S., we had a strong quarter from a bookings standpoint, driven by contributions from the Middle East, Canada, Australia, Ireland and England. However, revenue declined by 16%, largely due to a tough comparable related to technology resale.

For the year, we still expect double-digit revenue growth outside of the U.S., driven by the strong bookings in Q1, a good bookings forecast, and an easier comparable period for the rest of the year.

In the Middle East, we brought our pilot site live for the Ministry of Health in Saudi Arabia in just 9 months, which is a record for a global go-live. This is no small feat. It is a 500-bed hospital where we automated inpatient and outpatient physician and nursing workflows across emergency, surgery, laboratory, pharmacy and medical record departments. We also had 6 more hospitals in the Middle East achieve HIMSS EMR Adoption Stage 6, giving us 13 compared to just 1 for all other competitors combined. We believe this success positions us for more business in the region.

Now I'll cover a couple more marketplace observations. Health care providers remain focused on controlling costs and increasing quality, while juggling requirements for Meaningful Use, health care reform, Value-Based Purchasing and ICD-10. We believe IT is this -- the biggest lever to help providers navigate these changes and facilitate a transition to an at-risk model that incents keeping people healthy.

We also expect that as providers focus on controlling costs, they will continue to look at acquisitions to attain scale. As we've mentioned, this trend has benefited Cerner because our clients have been the most active acquirers, and we expect this to continue. Each of the last 2 quarters have included bookings contributions from clients buying solutions for acquired hospitals.

In summary, Q1 was a solid start to the year, and I feel good about a highly successful 2014.

With that, I'll turn the call over to Mike.

Michael R. Nill

Thanks, Zane. Good afternoon, everyone. Today, I'm going provide a quick update on our corporate imperatives. Recall that our imperatives are captured in the long acronym, PPR/CIM+1, with the PPR representing our focus on physician, population health and Revenue Cycle, and the CIM+1 representing continuum of care, intelligence, member engagement and personalized medicine.

I'll start with physician experience. With physician productivity being key to a clinical enterprise and Meaningful Use accelerating physician adoption, having solutions that optimize the physician experience is critical. As a result, we have invested and continue to invest heavily in physician experience and productivity. The record results for our physician solutions that we have experienced over the past 2 years are evidence that these investments are paying off.

We are also investing to support the evolution to a population health model in which the physician is going to take on a team managing thousands of people that are on registries. This brings me to population health. As you know, one of our development partners for population health is Advocate Health, who has over 500,000 lives for which they are financially at risk. So they are incented to keep people healthy.

We achieved a major milestone last year by releasing our Healthe Intent Smart Registries solution just 7 months from contract signing. Healthe Intent Smart Registries is part of our Healthe Intent cloud-based platform, which is a multipurpose programmable platform that aggregates, normalizes and standardizes clinical, financial and broader population data. While it is still early in the development of our population health solutions and the evolution of the market, we are pleased with our progress and believe we have the most comprehensive approach.

Third-party validation of this came in a Chilmark Research report about their experience at HIMSS, where they asked multiple purported population health solution providers to explain their process map for enabling a client to effectively move to a population health model of care. They indicated that Cerner was the only supplier to articulate such process map.

Moving to Revenue Cycle. We continue to have outstanding results that I believe are directly attributable to the large investments we have been making. While we have not added a full RevWorks client in recent quarters, our pipeline remains strong, and we expect 2014 to be another strong year for Revenue Cycle as a whole.

We also remain excited about the potential of our work with Intermountain Healthcare to build an activity-based costing system, which will further our differentiation.

Now I'll quickly cover the CIM+1 part of our imperatives. The first is continuum of care, which reflects the view that you have to include the entire continuum of care in any complete population health model. It's not just the doctor's office or hospital. Cerner has the broadest suite of solutions across the continuum, including solutions for home care, long-term care, skilled nursing facilities, behavioral health, rehabilitation facilities and employers.

In addition, we are proving the ability to connect to non-Cerner solutions across the continuum through our work with Advocate, where we are connecting approximately 70 data sources. Our ability to aggregate the information across the continuum, perform analytics and put the relevant information back into the workflow is a big differentiator.

Moving on to intelligence. Through the work with client partners, we have created industry-leading predictive capabilities for sepsis and readmissions that show our ability to embed intelligence in information technology. In the case of readmissions, the predictive algorithm we worked with Advocate to refine, performs 20% better than industry average and has been deployed at 120 non-Advocate sites.

Intelligence is also a large focus of our work with Intermountain Healthcare, where we have a huge opportunity to positively impact health care by embedding their care process models into our EMR-agnostic Healthe Intent platform.

Now I'll cover the member engagement. As organizations become accountable for not only the care but also the health of their patients, the way they connect to them will change. No longer are people just patients. Each person is now an important member of the client's population with whom they must engage and help manage their health and care needs.

In 2013, we enhanced our member engagement capabilities with the addition of PureWellness, a comprehensive wellness portal that reaches millions of members through employer, health plan and health system clients.

Finally, the +1 represents personalized medicine and the inclusion of the genome in diagnosis and treatment. Cerner has been focused on the power of genomics and its impact to the clinical processes, dating back more than a decade when we released Millennium Helix.

With the cost of genetic testing coming down, we are starting to see more opportunities in this area. For example, we announced in late 2013 that we are working with Claritas Genomics to advance personalized medicine by building tools to integrate ordering of genomic sequencing tests, laboratory processing, results interpretation and incorporation of the results into the EMR.

In summary, we are making great progress on all of our imperatives. This year, we expect to continue to advance these imperatives as we focus on helping our clients use our intellectual property as a lever to improve quality and safety while controlling cost.

With that, I'll turn the call over to Jeff.

Jeffrey A. Townsend

Thanks, Mike. As Mike shared, we've been accelerating our innovation and market validation through strategic partnerships. This is more than just traditional alpha site deployments. These are highly aligned engagements that enable us to work at the edge in a living laboratory environment that provides immediate feedback with short cycle times.

As we highlighted with multiple client presentations during our investor event at HIMSS, we have been given the opportunity to work side-by-side with these organizations as they transform towards a future state. For Cerner, this creates an environment where ideas and concepts can more quickly evolve into real world production solutions.

The byproducts of these relationships are much more than software solutions. It's about embedding the systemic framework for change, enabling what the Institute of Medicine calls a Learning Health System. To go a little deeper on what this looks like in practice, I'm going to provide an overview of what we are working on with Intermountain Healthcare.

When we announced the partnership, one of my early quotes was that this partnership could accelerate clinical computing by at least a decade. I still believe that. There are several areas of innovation that will contribute to this and over a few short months of engagement, the opportunity list continues to grow.

The first is around Intermountain's care process models. These are summarized guides to clinical decision-making, focused on both conditions and specific decision points within a care process. They are highly contextual, moment-in-time decisions that remove variance and produce the best outcome at the most appropriate cost, all in the context of the patient, provider and venue.

The system awareness of context is the most important part. It's what removes the clutter and noise. When done well, the system anticipates the next move. The ability to use a variety of trigger events to push the decision moments face up in the conversation makes the workflow dynamic. Think of it as a clinical navigation system, a GPS for medicine.

A big next step is making Intermountain's care process models EMR-agnostic, yet still inside the workflow. This will enable a new standard of care where we create the moment-in-time experience to support the decision, and at the right moment in time, it will surface contextually inside the workflow of the physician without upgrades, mapping of interfaces, or retraining of a workforce. This puts us on a path to accelerate a lot of the work done by the industry today by embracing and advancing current work more quickly.

We think these models have the potential to be the next generation of workflow, completely self-contained diagnostic, treatment, outcome and reimbursement containers. It could easily become the new transaction that replaces the claim in the fee-for-service world.

A key enabler, much of what we are doing, is our commitment to having the most open and interoperable EMR platform on the market. Most of the discussion today around interoperability is pretty basic and moving at a very slow pace. At HIMSS, Cerner and Intermountain showed the power of blending an emerging set of standards we have tagged Smart on FHIR. Using the SMART standard to provide plug-in web experiences within the workflow and HL7's Fast Health Interoperability Resources, commonly referred to as FHIR. We showed the ability to plug non-Cerner and non-Intermountain applications into the workflow contextually.

One example was showing a consumer-friendly growth chart app developed at Boston Children's, spanning both Intermountain's existing clinical system and Cerner Millennium to create a continuous story. This allows us to more rapidly unlock the same potential for open platform development that has been experienced in other industries, which we believe will disrupt the current paradigm of how an EMR is used in the delivery of health care.

What we were doing with Intermountain and what have already been done with Advocate around interoperability and realtime analytics is a big differentiator for Cerner. Many of you probably saw dozens of booths that HIMMS highlighting a data warehouse, showing elegant graphs that purport to provide great insight into the data. However, if you can't get that insight back into the workflow when the physician is making the decision, at what I call the moment of relevance, then you're just reporting the news versus making the news.

Another focus of our innovation with Intermountain is with their transformation lab, where multiple technologies and partners come together to innovate in a startup-style environment. One of the examples I talked about at HIMSS was advancing past device integration and the interoperability to environment orchestration with our CareAware platform. For example, with the ability to continuously stream vitals off of devices, the physician's order for IV meds can be placed to give a medication until a vital, such as heart rate, reaches a specific range, and once it gets into that zone, then taper back or stop the medication.

The ability to coordinate devices to create an outcomes-based ordering capability is very plausible, and will have a predictable impact on quality, cost and outcomes.

The last area of innovation I'd like to cover is what we're calling an activity-based EMR. The core component here is to dissect all the activities of medicine in LEGO-like components so that you snap them together around a purpose. Dr. Brent James at Intermountain has done a lot of work in this space and has componentized a large number of procedures, activities and what he calls risk force [ph], those number over 800, which are drivers for clinical care.

This ability to group things together into components and have the option to now snap together workflows that drive change rapidly into the clinical process while knowing costs, measures and outcomes is very powerful. What is unique about the approach we're taking together is the inclusion of goals and outcomes associated to the activities. If you look at just costing, with a pure resource or consumption-based model, you miss the fact that the activities were aligned to an expected outcome. In some cases, those outcomes are events or risks you're attempting to avoid.

While the cost of a manual capture of vital signs versus a wearable continuous device will be different, the ability to constantly monitor the patient's status continuously changes the outcome risk well beyond the comparable resource costs of collecting the data.

If you're going to attempt to impact appropriateness, costs and quality at the same time, you have to include expected and actual outcomes mapped to activities.

In summary, the most exciting part of this partnership isn't the individual innovations or the potential impact they can have. It's the next generation of Cerner's consulting methodology rooted in agile development techniques, being applied to support both the implementation of core solutions and the continuous overlay of new solutions and decision support capabilities.

A key objective is to move away from the traditional waterfall IT approach of static, one-size-fits-all projects, to a more nimble, continuous innovation environment that anticipates and embraces change. In the case of Intermountain, we are running on a 6-week model system release cycle, producing workflows, contents, solutions and education materials that come together into a comprehensive release.

This approach creates a culture of continuous improvement versus a one-time conversion mentality. The emerging toolkit from the methodology, combined with activity-centric design and componentized care decisions, on top of an open platform, are the foundational building blocks of the next generation of clinical computing.

This is very important work, and we have a sense of urgency driven by entrepreneurial impatience, sense of responsibility to improve the overall system and competitiveness. This urgency also comes from our belief that the rest of this decade will include more changes in health care than what has occurred in the last 6 decades combined.

The solutions will need to keep up. IT organizations will have to reinvent their methods, and provider organizations will demand a more dynamic and contextual experience. Our role has always been to anticipate the future of health care and create solutions to meet those needs, and now is the window to accelerate.

With that, I'll turn the call over for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Ricky Goldwasser with Morgan Stanley.

Your next question comes from line of Richard Close with Avondale Partners.

Richard C. Close - Avondale Partners, LLC, Research Division

So just a real quick question because I know there's probably a log jam here. But just on the RevWorks, you commented that you haven't seen anything in the last couple of quarters. Can you just talk a little bit, maybe, about what's holding up additional contracts from coming into the bookings? Are you seeing increased competition, the likes out there of Optum and Dignity, obviously, you got Conifer and Parallon and some of those. Just give as an update on your view of that -- the lay of the land in that area.

Zane M. Burke

Richard, this is Zane. I would actually describe it more as when we thought ICD-10 was going to occur, there was more of a natural holding in terms of when you would take one of those RevWorks opportunities from a transition perspective, when it would make sense. So with the delay in the ICD-10 piece, we think that it makes sense that some of those will actually come forward a little bit sooner now, and we see some really good opportunities in that pipeline. But so I don't see it really from a competitive perspective, it's really more of a natural progression in the timeline.

Richard C. Close - Avondale Partners, LLC, Research Division

Okay. And quick follow-up with respect to patient financial accounting system on the Rev Cycle. I think you mentioned the opportunity to be able to jam in some systems due to the delay. Is there any type of quantification you can give in terms of what you would expect, size of bookings, in that product area?

Marc G. Naughton

Yes, Richard, this is Marc. We wouldn't have any specific guidance relative to the Rev Cycle solutions. The demand is in our pipeline, and certainly, it would be reflected in the bookings guidance we provide. But it does feel like with ICD-10 being pushed, the people are starting to look at acquiring financial systems probably for implementation after ICD-10 goes live and we're starting to see that activity.

Zane M. Burke

Before. I'm sorry, before ICD-10 goes forward, not after.

Operator

Your next question comes from the line of Mohan Naidu with Stephens.

Mohan A. Naidu - Stephens Inc., Research Division

Jeff, on IFC Intermountain, are you guys already replacing the health system they are using, or how far along are you guys before you can do that?

Jeffrey A. Townsend

We're still -- we're just a few months into the project. But the expectation is that we'll replace both HELP and the HELP2 system starting later this year.

Mohan A. Naidu - Stephens Inc., Research Division

All right. And just a follow-up on the same thing. On the care process models that you talked about in innovation, are you guys planning such a way that you can take that out and offer it to other clients? And how does that -- how do you expect that to work?

Jeffrey A. Townsend

Yes. So the plan is to not only develop them, the run-in type of systems here, but to have those externalized so that they cannot only be used by existing Cerner clients but non-Cerner clients, as well. And we have a short list of candidates we've started working with inside the base that will pilot that for us this summer.

Operator

Your next question comes from the line of Greg Bolan with Sterne Agee.

Michael P. Ward - Sterne Agee & Leach Inc., Research Division

This is Mike Ward in for Greg today. We just have one quick question. If you think about your current lot share of the installed base of hospital clients, how much room do you think there is to grow?

Marc G. Naughton

The question is based on, number one, our installed base, the opportunities within the installed base. Certainly, a lot of our growth is predicated on taking market share in addition to our installed base. I think the level of growth, when you look at just some of our newer offerings such as RevWorks and ITWorks, when you only have double-digit-barely ITWorks and single-digit RevWorks and 300 clients that could take those offerings over time, that's a pretty large opportunity. And it's actually dollars already coming of their wallets that they're already spending, that they would merely redirect to Cerner. Those are -- we use the pretty good chunks of dollars that would come into us. So I think relative to the -- to our current share of their wallet, while we're certainly an integral part of their IT strategies, many of our large clients don't even have Cerner throughout all of their hospitals. So it is a process that they've undertaken and continues to be underway. So there's opportunities to sell more into the base as they expand. Certainly as the market consolidates and they acquire more hospitals, there's more chance to expand. So I don't know that -- I don't see us limited based on our current market share of wallet. I think there's plenty more opportunities for us to go get more business out of the existing client base, in addition to the other opportunities we see out there.

Operator

Your next question comes from the line of Steven Valiquette with UBS.

Steven Valiquette - UBS Investment Bank, Research Division

So with the ICD-10 delay, it sounds like it's opened up some conversations on new RevWorks projects, which is obviously positive. But I guess, I'm curious, is there any chance you've seen any uptick in conversations on new EHR projects since the delay? I mean, has there been any shift in the focus of clients away from RCM and back towards the EHR with the delay? Or is it maybe too optimistic to make that assumption? Just kind of curious to get your thoughts on that.

Zane M. Burke

This is Zane. We haven't -- I haven't necessarily seen whether that piece is out there yet. It's not reflected in our guidance at this point in time. But I think there is a sentiment as people figure out how they're going to shift their projects. They're clearly going to look at other things that they can go accelerate. And so that's a net positive. I certainly have been pleasantly surprised overall by the number of -- when we talked about the second buying wave. The second buying wave could accelerate some that long-term bubble that we see out in the future of clients that are -- or prospects that actually have achieved even as high as HIMSS Level 7 on other providers and are yet active in the marketplace, at -- looking at exchanging their EHR because they don't feel like the solution they have will suit their future needs. So I do think there are some opportunities in that with the push of ICD-10.

Steven Valiquette - UBS Investment Bank, Research Division

Okay. And I guess, so besides the RevWorks that you mentioned, are there any other product categories that are noteworthy and then you've seen an uptick in interest since the delay? Any other shifts that are worth mentioning?

Zane M. Burke

Not at this time. I think some of the integrated ambulatory -- because of the issues with the physician documentation requirements for ICD-10, I think we will see -- I haven't seen it yet, but I do think we will see that ambulatory uptick will continue for us and that we'll have continued strength in the ambulatory side. And that shift in ICD-10 could have a net positive to us from the ambulatory side.

Operator

Your next question comes from the line of Jamie Stockton with Wells Fargo.

Jamie Stockton - Wells Fargo Securities, LLC, Research Division

I guess, maybe the first one, Zane, I think this is for you. Stage 2 of Meaningful Use, it doesn't seem like there's been a lot of attestations across any of the vendors so far. Can you give us some sense for how you feel like hospitals are faring in that?

Zane M. Burke

Sure. We did actually have our first attestation. And so, as you know, the publicly available data is lagging in terms of what else is out there, but I will tell you, we did have our first attestation in the first quarter. And we anticipate a significant number of clients here in the second and third quarters and tracking that very closely. And we're working with those clients to develop the plans for how they'll be rolling out. So I would anticipate you'll see Cerner clients in the second quarter, a very significant chunk of those attesting at this point. As far as competitors, I have not seen any other competitor that has attested for Stage 2 Meaningful Use yet at this point. But again, the publicly available data is lagging by about 60 days.

Jamie Stockton - Wells Fargo Securities, LLC, Research Division

Has the experience of the hospitals that have been going through that attestation process, I mean, has there been any, I guess, unexpected hurdles that you have been hearing just from the feedback you've been getting?

Zane M. Burke

I think every time -- anytime you're doing new things, you get -- there's always some twists and turns and every environment is a little bit unique to the organization. And so as you go through that, there's some tweaks. But overall, our clients are tracking very well, and that we've got a discrete plan for every single client that we have out there around Meaningful Use 2 and we're -- to ensure that they achieve the dollars that they deserve to achieve.

Jamie Stockton - Wells Fargo Securities, LLC, Research Division

Okay. And then just on CommunityWorks. From the hospitals that we've been talking to, it feels like maybe 2014 is kind of the first year where you're seeing a lot of the smaller facilities that are in the orbit of larger health systems start to look at transitioning to whatever system that large health system that's geographically closest on. Are you guys feeling that in the marketplace? Or has that already been a trend that's been going on for a while and we're just now picking up on it with our checks?

Zane M. Burke

Well, I think you are touching on one element that is becoming more about where health systems are identifying or kind of caught more of that feeder system to their overall broader strategies, and the Critical Access Hospitals are wanting to connect -- or the big systems want those connections to mature. And so we are seeing that out there, and I would call that probably more of a future development. Obviously, we've highlighted some of the acquisition activity, which there's kind of -- so there's sort of the 2 forms: the affiliation and tighter linkage, or acquisition model. And I think you're going to see more of joint ventures, more affiliations, along with -- I do anticipate an uptick again once -- because of the ICD-10 delay, I think you'll actually see an uptick back again on the acquisition side.

Operator

Your next question comes from the line of David Francis with RBC Capital Markets.

David K. Francis - RBC Capital Markets, LLC, Research Division

A couple of longer-term growth-oriented questions. I think, Zane, this one is for you. Understanding the need for care coordination and population health in the health care marketplace, as you look at your customers, how would you characterize where the provider market is today from both an operational and a cultural perspective, to actually be able to use the IT tools that you guys are developing for that part of the market today?

Zane M. Burke

It depends, very much, on the geography, so -- and the management teams, overall. So those geographies where -- and clients that are more risk-oriented are -- they're ready for the tools today. There are certain geographies and certain clients that are not either -- they don't have -- they're not necessitated to actually go swim towards a risk yet today because their model is more -- is still the fee-for-service and they don't see it coming. Or they're, frankly, hoping against hope that the old model will stay. And so those clients are not quite as far along in their thinking -- their thought process there. So I would describe is the early movers are ready for the tools today. Those that aren't the early movers, it's a little bit more evangelical conversation that we have with them.

David K. Francis - RBC Capital Markets, LLC, Research Division

And when you say ready, do you mean from a, we've bought into the concept perspective, or that we are structurally ready from -- in incentives, in a reorganization of the operating teams and all of that kind of stuff that needs to happen, as well?

Zane M. Burke

Yes, there's varying degrees. There are those on the very early side that are fully ready. They're absolutely moving towards the risk in advance of even the models being out there, so that such that they're prepared. And we actually have a number of clients today that are full incentives, changing their workflow models and changing, really, the way that they think. And they have one foot in the fee-for-service model and one foot in the risk side. They're fully in, so they're beginning to think about the at-risk even at the expense of the fee-for-service model because they know it's the inevitable future.

David K. Francis - RBC Capital Markets, LLC, Research Division

Okay. And as a quick follow-up, turning over to Revenue Cycle. To what degree have you looked at or are you changing your Revenue Cycle solutions to address the increase high-deductible health plans that are being sold in the market today and going forward? And the increase in direct patient payment portion of the overall healthcare spend as it relates to your clients' Revenue Cycle needs?

Zane M. Burke

We're always -- the ever-changing environment out there, there's continual revisions to the solutions and elements that we do. But it's -- that's not been a big driver in our immediate elements. But we're clearly very close to how the thought process is there and how the future is going to play out.

Marc G. Naughton

It's part of the reigning measures and mandates that we continue to see. This is Marc, and we just -- certainly, the software keeps up with all of the regulatory requirements that are going in the business, baked into the business needs of our clients. So we are ready for them.

Operator

Your next question comes from the line of Eric Krueger with Barclays.

Eric Krueger

I'd like to ask about the international market. I know that you see strength ebb and flow in this market. I'm curious, hearing about the go-live in Saudi Arabia. How much of what you're targeting is advanced systems for hospitals versus other geographies where you may be looking at the most simple system to get through the door and up and running?

Zane M. Burke

That's a great observation. As you're obviously aware, certain global markets have lower levels of clinical automation. I would tell you that the Middle East has actually a very high level of clinical automation. So it's a very -- it's a much heavier depth of automation than many other global marketplaces. The Saudi space is very much -- and the Middle East space is very much a deep clinical thought process.

Eric Krueger

And are you going into areas where you are starting with a strong base, or is it that you're starting from scratch with a very high funding and bar to hit?

Marc G. Naughton

For Saudi, it was a single pilot. We were just [ph] selected. Their process was to select a single pilot. We've turned ours on and we've delivered. We don't know that any other pilots have even started in that process. So we believe that the first to market, first to install, first to see the benefits is going to give us an advantage. But currently, once again, they don't have a large procurement in place. They are doing it on a hospital-by-hospital basis. We're just very pleased that we have our first one up and running and doing very well.

Zane M. Burke

And I'll just -- for color purposes, in the rest of the Middle East, I think you see a lot of early demand for population health tools because those countries are thinking at the population health level. And so they are thinking about things just a little bit differently, and I think you'll see them move more quickly over time because they have the ability to do it in the contained, smaller environments and in a way that they can regulate. I think that there's quite a bit of demand in the population health side in the Middle East.

Marc G. Naughton

Eric, this is Marc. I would just point out that inside the tender we're in, we already have a lot with us, in multiple private hospital clients in Saudi. So we certainly aren't looking at our first footprint in the country, we have multiple footprints there. And if you look overall in the Middle East, we have an order of magnitude more HIMSS Level 6 clients in the Middle East, so I think that supports Zane's point of these are complex clinical environments, and I think that's supported by the HIMSS level we're seeing in our client base.

Eric Krueger

And could you just remind be the tender, your next step or the size of the opportunity you hope to address?

Marc G. Naughton

There's no prescribed next step once we deliver the pilot. It's up to them to take the next step. There are well over 200 hospitals that would qualify for this opportunity. And so that's kind of the order of magnitude.

Operator

Your next question comes from the line of Leo Carpio with HM Global.

Leo F. Carpio - HM Global Capital LLC, Research Division

I must -- I'm just going to change the tone of the conversation. What have been the competitive environments so far in terms of the deal flows you're seeing this year, in terms of who you aren't able to be competing against, and since you're anticipating a replacement cycle, it sounds like your prospect is that maybe a duopoly is just going to emerge and become the factor by next year in the market for you?

Zane M. Burke

I think you just answered your own question, which is we do see it as a duopoly, that principally who we are competing against is one other competitor. Sometimes you might have an incumbent that is given an opportunity in that particular organization, to have an opportunity to compete against the 2 of us in that side. And so that's typically how a typical arrangement would go. For us, we've seen a 20% increase in our pipeline since Q1 of 2013. So when we look at the opportunity side of this, we're seeing an acceleration of pretty dramatic opportunities across all segments of our business.

Leo F. Carpio - HM Global Capital LLC, Research Division

Okay. And then just quickly, the ICD-10, you mentioned that this part could be a positive for you for this year. Is -- and that some cost probably [ph] will be reshuffling their priorities and figure out what products they want to move forward with. Is that more a case of the midsized hospitals? Or is it just, in general, that you're seeing that?

Zane M. Burke

It's, in general, that we're seeing that. So I think there is an ability for some of the midsized hospitals to move a little bit quicker because it's single projects, and their planning cycles can be a little bit different. But those ICD-10 resources can be reapplied somewhere else. And many of them were planning to do a Revenue Cycle selection after the ICD-10 element, which now allows them to think about doing it now. And the same thing goes on the RevWorks side of that conversation.

Operator

Your next question comes from the line of Garen Sarafian with Citigroup.

Garen Sarafian - Citigroup Inc, Research Division

First question is a pretty broad level and on EMR displacements. So I guess, I'm a bit surprised to hear the strength of the displacement market for the EMRs this year as we talked to industry participants. So I'm just wondering, could you just offer a bit more color as to what you're seeing versus maybe what you were thinking a few months back, or any changes in the pockets of opportunity? And I guess, also, just the vendor group that you're competing against, if there's been any changes?

Zane M. Burke

Well, we've been highlighting this second wave for quite some time and actually, we believe it's a 5- to 7-year wave of second buying. And I think that recently, Class actually verified what we have been saying as a second wave of buying decisions. And again, as evidenced by the 20% increase from my pipeline, which is also inclusive of my new client, which is actually in excess of 20% increase over Q1 of 2013, we're seeing it flow through and, again, it's -- the competitors are -- our principal competitor and the incumbent that exists out there, primarily.

Garen Sarafian - Citigroup Inc, Research Division

Okay. So -- it's -- but I guess, there's no change versus your expectations a few months back then. It's sort of as expected?

Zane M. Burke

I think the only thing that's evolving probably a little bit different for me is I've seen, as I mentioned then from a color perspective, some clients which you would say are highly automated today have reached a good level of automation with an incumbent solution. But they feel like that foundational solution won't last -- stand the test of time, are beginning to think about changing their core EHR solution. And I would say some larger organizations fit that model that I wouldn't necessarily would have been -- thought they would have been in the marketplace. And I can see them coming into the marketplace over the next 12 months.

Garen Sarafian - Citigroup Inc, Research Division

Got it. Okay. And then secondly, just not to beat the ICD-10 topic to death. But at this point, would another delay beyond next year really matter for your business? I mean, what are clients saying at this point? Are they making any decisions around ICD-10 for next year?

Zane M. Burke

At this point, no, they're not really making any -- they're on -- they're kind of on standby to secretary discretion on how this works. And so they're just on standby. And I think they're going to begin the plan as if it's not there, would be sort of my -- for my sense. Now many of them had invested heavily to prepare, and we're advising our clients to stay on the prepared path because you don't want to waste the work. In fact, if it is -- actually comes in within a year, but I think most clients are -- will pretend as if it's not there unless they weren't ready for it at this point in time, in which if that's the case, that gives them an opportunity to take a second swing and get actually prepared for that.

Operator

Your next question comes from the line of Charles Rhyee with Cowen and Company.

Charles Rhyee - Cowen and Company, LLC, Research Division

Marc, just had a quick question about the guidance going forward. You talked about your expectations on the margin expansion, 100 basis points, rest of the year. Did I hear you correctly when you said second quarter may be a little bit less than that? The back half a little bit more? And then if that's correct, in the back half, does that -- are you kind of thinking both quarters are like that, or wouldn't we just lump 2 of these together, in aggregate, it will be greater than 100?

Marc G. Naughton

Yes. No, I think on a quarterly basis, the expectation would be Q2, a little bit lower, Q3 and Q4, a little higher, so that for the year, we end up with our 100 basis-point improvement. I think it's important when you look at Q1 where we kind of actually have just, basically, flat operating margin percent, that even in a quarter where we had tech resale go down, which normally will help us with our margins, that the client tech resale actually was almost equally offset by a 27% increase in software. So our revenue line was solid, and obviously, I like the higher margin. But in Q1, we also had some significant investment in R&D expense and some increases in some G&A, along with the client services expense that increased, to support the strong increase in net revenue. I think from an overall standpoint, Q1 came out very good for us. We love the dollars we drove out. But certainly, a little bit lower on the margins. We think that will kind of settle back to the 100 basis points by the time we end the year, with Q3 and Q4 being at a higher level than you'll see in Q1 and Q2.

Charles Rhyee - Cowen and Company, LLC, Research Division

Okay. And then just 2. When I think about the back half because, obviously, you gave us what you think the expense -- the aggregate expense will be in the second quarter, should we think that the margin improvement, as we accelerate north of the 100 basis points, will be more from gross margin or is it more from taking expense out further?

Marc G. Naughton

Well, it should be, basically, the continuing -- you'll see more leverage from kind of overall spending where you're going to see revenues increasing at a rate that's higher than our spending's increasing. Traditionally, where you see that is in our leverage.

Operator

Your next question comes from the line of Michael Cherny with ISI Group.

Michael Cherny - ISI Group Inc., Research Division

Marc, first, one quick clarification. Did I just hear you right when you said 27% software growth in the quarter?

Marc G. Naughton

Correct. And in fact, I had a 27% decrease in tech resale on the revenue side. So it just so happened, from a revenue standpoint, those basically offset. Obviously, I'm really excited about the software increase and, well, disappointed that the tech resale was lower when we were getting to a point where we're not going to talk about that anymore. The pipeline for tech resale would indicate that it will get back to the levels we had -- basically, that we had expected where we were basically trending somewhere, where we were last year.

Michael Cherny - ISI Group Inc., Research Division

Yes, I think we're all excited to stop talking about that. So think I'm in the same camp as you. And then one just quick question on the international market. We touched on Saudi Arabia and this great success you had there. As you think globally about the countries that you're in, maybe outside Saudi Arabia, just because of the recent focus, what do you think is the one country or region that you think has the greatest opportunity to pursue a U.S -like model, a broader-based digitization of the health system? Is it somewhere like Brazil? Is it somewhere like the U.K., finally getting their act in gear? I guess, what's the most optimistic international market for you guys?

Zane M. Burke

Well, this is Zane. I think the U.K. does represent, from a near-term perspective, one of the biggest and best opportunities. I think that people are -- in the U.K., as they come out of NHS trust model, are recognizing a need to actually have deep clinical systems. And I think those trusts that are more progressive and forward-thinking are headed that way. And I have spent some time with some clients recently who are -- who have come to that conclusion even at the risk of their having to pay significantly additional dollars from the -- as opposed to going to the open-source NHS model. So I think that represents a great opportunity for us. I think Australia is still -- is a very good market, broadly speaking for us, in addition to the Middle East. And I think Brazil is a longer-term play that we'll have to see how that rolls out.

Marc G. Naughton

And this is Marc. I think we're even seeing an aggregation of populations in Canada, as well as part of their health system is going more provincial and trying to get almost an entire province on a single platform so they can manage the health of that population. So -- and I think that Australia, obviously, with the Queensland activity, as they're doing an entire territory. So think those -- and then I actually talked earlier about Middle East being countries -- those countries aren't large and they can actually automate a population health strategy in the entire country without having to -- so lots of opportunities on the global side.

Operator

And the final question will come from the line of George Hill with Deutsche Bank.

George Hill - Deutsche Bank AG, Research Division

Just one quick question. Marc, I wasn't able to get the trend file open yet. Can you tell me what the percentage of bookings that came from new clients into the quarter was?

Marc G. Naughton

25%.

George Hill - Deutsche Bank AG, Research Division

25%. Okay. And then just kind of a follow-up question on the bookings. If we look at this quarter's bookings, I don't know if you can break it down into just broad buckets for us, but if there's 25% that comes from new, I guess, can you tell us like what percent is coming from cross-sell and what percent is coming from renewals, kind of what percent is coming from, what I would call like the meaningful client expansion -- call it, 2 buckets, right? Client expansion of people who buy more widgets from you and people who acquire facilities and then need to roll the technology out to acquired facilities? I guess, I'm just trying to understand what bookings mix is looking like these days?

Marc G. Naughton

Yes, this is Marc. I think from a view, keep in mind that most of our sales are perpetual license, so there's not so much a renewal element. To ours, we certainly have an element subscription business that's part of our revenue stream, but not a huge part of it. Most of the bookings are coming from new sales of software, they're coming from new sales and services, from implementation, from a variety of support services, Business Office. There are some minor amount of, say, hosting renewals that occur. But for the most part, George, I would say that the vast majority of those bookings are new agreements for new things to those clients.

George Hill - Deutsche Bank AG, Research Division

Okay. And then so, I guess, when you get the big Works deals and the bigger -- I guess, the bigger deals, we didn't see any of those this quarter, and that's what we'll see in the future, continue to drive the upside to numbers. And kind of a lot of these cross-sell opportunities are what should remain the kind of visible bookings opportunities, is might be the right way to think about it. Or the opportunities that will kind of be readily available from the installed client base.

Marc G. Naughton

Yes, I think that's fair. I don't know that the Works things do have some level of visibility because they're big. Certainly, they've got some risk-down factors, to the extent, as we're providing guidance. But I think that's a fair statement.

Well, I appreciate everybody attending the call today. Neal is not here for a wrap-up. So I just want to thank you for attending. I know we ran a little late. And I hope you heard a good story here. We're excited about the rest of this year as our pipeline is firming up well and we see a lot of opportunities. So with that, enjoy the rest of your day. Thanks for attending.

Operator

Thank you for your participation in today's call. This concludes the presentation. You may now disconnect, and have a great day.

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